Wednesday, November 6, 2013

As reported yesterday by Jeff Cox of CNBC, the Fed is likely on the verge of making an important policy change (HT: Calculated Risk). Within the next several months, the Fed is likely to announce the tapering of QE. That's not a big surprise, but this time there is an interesting twist: in order to offset the risk that tapering might cause interest rates to move higher—which could slow the still-weak housing market and the still-weak economy—the Fed will also announce a lowering of the unemployment rate threshold that would prompt them to begin raising interest rates. By doing this the Fed would be removing some of the unwinding risk that continued tapering creates, while at the same time keeping bond yields from increasing, since a lower unemployment rate threshold would significantly extend the period during which the Fed would keep short-term interest at or near zero.

The official justification for this move would be to strengthen the economy. But for those of us who believe that monetary policy has little or no ability to create economic growth, the real reason the Fed would make this move is to aggressively weaken the demand for cash and cash equivalents (e.g., currency, T-bills, bank savings accounts, and bank reserves). If the Fed succeeds in convincing the world that cash and cash equivalents will pay next to nothing for the next few years (i.e., the time it would take for the unemployment rate to fall to the Fed's new threshold), then the world's demand for that cash is most likely going to decline.

As the chart above shows, there's an awful lot of "cash" out there that pays almost nothing: over $7 trillion of bank savings deposits, $0.7 trillion of retail money market funds, $0.6 trillion of small-denomination time deposits, and $1.4 trillion in checking accounts. And let's not forget the $2.5 trillion of bank reserves, the vast majority of which are held as "excess reserves," that the nation's banks are apparently quite happy to hold and which pay all of 0.25%.

The M2 measure of the money supply is arguably the best measure of the amount of readily-spendable cash in the economy. As the chart above shows, the ratio of M2 to nominal GDP is at record-setting levels. That means that the public's demand for "cash" has never been stronger. Households and businesses have never before held such a large proportion of their annual income in cash. That's remarkable on its own, but it's even more remarkable considering that the yield on all that "cash" has never been so low for so long (T-bill yields have been hugging zero for the past 5 years). It's a fact that the world's appetite for "cash" has never been so voracious.

The flip side of today's strong demand for cash is a high degree of risk aversion. People are apparently content to sit on a mountain of cash earning almost nothing, while any asset with risk attached yields considerably more (see chart above), and total returns on most of the world's stock exchanges have been on the order of 20% so far this year.

There's an old saying: "Don't fight the Fed." The Fed is arguably the most powerful institution in the world, and when they want something, they can get it. What they want is for people to be less risk averse: to spend some of their cash stockpiles, to hire more workers, and/or to expand their businesses. If they succeed, and they most likely will, then the world will attempt to reduce its holdings of cash and increase its holdings of riskier assets. Of course, cash can't simply disappear, so the mere attempt to reduce cash holdings will mean that the relative prices of cash and riskier assets will change: riskier assets will go up in price (and down in yield), while cash will go down in price (and eventually up in yield when the Fed decides that it has achieved its objective).

What I've just described has actually been going on for some time now. What the Fed is likely to announce in a few months won't be anything new, it will just be trying harder to do what they started to do in 2008. As the chart above shows, corporate credit spreads have been contracting for the past five years (i.e., the difference in the yield on corporate bonds and the yield on Treasuries of comparable maturity has been contracting). The world has been willing to pay an ever-higher price for corporate bonds relative to Treasury bonds because risk aversion has been declining. But spreads are still quite a bit higher today than they were before this whole mess started, so there is still plenty of room for improvement.

And of course there is the huge rally in most global equity markets, which directly reflects the decline in investor's risk aversion, bolstered by record-setting corporate profits. Yet PE ratios are still more or less average; despite record-setting profits, investors are still reluctant to pay above-average prices for those profits.

If the Fed gets its way–and I have little doubt that they will—then all of the things we've seen happen over the past several years will continue. The prices of risky assets will continue to rise, nominal GDP will continue to expand, and bank lending will continue to expand. C&I Loans are already up by one-third in the past year. Banks have been slowly relaxing their lending standards for the past year or so, and that is very likely to continue. We could even see a pickup in real economic growth, but it's not likely to be very impressive unless fiscal policy takes a turn for the better (e.g., fewer deductions, lower rates, cuts in the taxation of capital).

As risk aversion declines, the price of gold—the classic refuge from monetary and political risk—could decline as well. Gold is still trading at more than two times its average inflation-adjusted price over the past century.

The end game is still out there on the horizon. That will come when bank lending becomes aggressive and the amount of cash out there starts increasing faster than the world's demand to hold it. At that point inflation will begin to pick up and the Fed will need to start chasing it by increasing interest rates. Eventually the Fed will raise rates enough to boost the demand for cash to such an extent that the world loses its desire to engage in risky behavior, and the economy will turn down. It's the same story that has played out in just about every business cycle in my lifetime.

There's not much new under the monetary sun these days, it just goes by another name. Traditional Fed easing was accomplished by lowering interest rates; nowadays it takes a reduction in the unemployment rate threshold for Fed tightening.

9 comments:

Maybe there are more people, running barbell risk models, as in Nassim Nicholas Taleb's book _Antifragile_, than one might otherwise suspect ? Meaning, 15+% return on a small amount of mortgage-REIT (or HY equivalent) can make holding a much larger amount of cash palatable if one's expectations are still tamped down by fear and low inflation. If you have already dispelled this notion elsewhere I apologize for my RTFM failure.

Interesting wrap-up. Yes, the Fed does not want to cut QE and wants a lower threshold on the reported unemployment rate before doing so.

I remain mystified that there is so little discussion about the 0.25 percent IOER paid by the Fed to member banks.

If it is unimportant, why does the Fed pay IOER?

Is is simply a sop to banks, a reflection that central banking is run, after all, by banking interests?

Does lowering IOER by a basis point a month make sense?

I also remain mystified that the Fed, with all of its blah-blah on forward guidance, is entirely mute when it comes to describing its exit strategy from its $3.7 trillion balance sheet. Does it plan to "roll over" and in essence maintain the balance sheet for a long time? That would have the impact of permanent debt monetization, a perhaps good idea at this point.

Side note to for Scott Grannis: Okay this is a whacky one, but stay with me: Let us say most people already bought their houses, and have fixed mortgage payments.

Therefore, their cost of living is not going up, and, in fact, if they buy electronic goods, or like Internet-based entertainment and reading, their cost of living has been going down for a long time.

So this group is experiencing deflation or close to it. So they are happy to stay in cash, just as their counterparts in Japan are happy in cash. It is riskless and not losing its value. These people may have lost money on Wall Street to boot.

There is some evidence the CPI, and even the PCE deflator, overstate inflation (see Don Boudreaux).

When I shop in dollar stores or look on Craigslist for deals, I wonder if the price indices capture everything. The world's retail markets rapidly evolve continuously.

Interest rates are headed dramatically higher: the expansionary part of the credit cycle ended on October 23, 2013, as the Interest Rate on the US Ten Year Note, ^TNX, rose from 2.49%, causing World Stocks, VT, Nation Investment, EFA, and Global Financials, IXG, to turn lower from their PBOC Monetary Stimulus, and US Fed No Taper, and ECB Bank Supervision Rally highs, as bond vigilantes now have control of Interest Rates globally, enabling currency traders to short sell major world currencies, such as the Euro, FXE, and emerging market currencies, such as Brazilian Real, BZF. It has been the currency carry traded countries which have experienced the greatest debt deflation since the world entered Kondratieff Winter on October 23, 2013, as is seen in the combined ongoing Yahoo Finance chart of Turkey, TUR, Argentina, ARGT, Brazil, EWZ, EWZS, and Indonesia, IDX, IDXJ.

Given the failure of money, that is stocks, credit, and currencies on October, 23, 2013, economies cannot and will not grow; expect economic contraction, especially in China which saw a dramatic rise in fiat asset values, beginning in late June 2013, only to experience a sell off since October 23, 2013, as is seen in the combined ongoing Yahoo Finance Chart of YAO, CHIX, CHII, ECNS, and TAO.

Liberalism was the age of investment choice, which came from the world central bank’s loose monetary policies and banker schemes of credit and currency carry trade investment. Liberalism’s flag was the Milton Friedman free to choose fiat money system.

But Jesus Christ, acting in dispensation, a concept presented by the Apostle Paul in Ephesians 1:10, that is in the economic and political plan of God to complete every age, epoch, era and time period, fully matured liberalism on October 23, 2013, producing its peak money experience, as is seen in the value of risk free money, Short Term Bonds, FLOT, trading lower.

Jesus Christ, has pivoted the world into the age of diktat, featuring the world central bank’s antifragile financial system, an Alberto Mingardi Econolog Econolib term, where the banks, that is all the banks, the Too Big To Fail Banks, RWW, the Regional Banks, KFE, the Nasdaq Community Banks, QABA, the Savings and Loans, are going to be integrated into government, and will will be known as the government banks, or gov banks for short, as is seen with the ECB announcing a plan to supervise 130 European Banks, and the UK Central Bank providing the new monetary policy tool of the Revised Sterling Monetary Framework, and the US Federal Reserve providing two new monetary policy tools, that is Fixed Rate Full Allotment Reverse Repo Facility, and the Liquidity Coverage Ratio, where nannycrat schemes of diktat and debt servitude will prevail. While Scott Grannis writes The Fed's Objective Is To Destroy The Demand For Cash, I believe that the Fed’s objective, as well as all the other world central banks’ objective, is to corner all cash and place cash everywhere under regional control as part of the growing dynamic of regionalism which is replacing globalism. Authoritarianism’s flag is the diktat money system.

There is a risk reward relationship in all things, and it is a fundamental reality to investing. For every investment there is a reward. When risks arise to lessen the rewards, or when risks arise which present the risk of losing one’s investment, then one sells, and seeks a safe haven and safe haven assets.

I do not consider money market funds or saving accounts, safe investments, as they are all bond based, and are likely to be subject to capital controls.

Inasmuch as the world has pivoted from liberalism’s risk-on age of investment choice to authoritarianism’s risk-off age of diktat, risk aversion will drive investors out of traditional safe haven investments, such as savings account into gold, the classic refuge from monetary risk and political risk. The age of the investment demand for gold commenced in July 2013, as is seen in the chart of the gold ETF, GLD.

Note that the weaker demand for cash that I am forecasting is not the same as saying I think the dollar will weaken; those are two very different things. I'm not saying anything about the value of the dollar relative to other currencies in this post.

I don't see clear implications for the value of the dollar here. The Fed has been trying to undermine the demand for cash for years now, and the dollar has not gained or lost value materially. In the very long run (years) I think the dollar can gain value vis a vis other currencies. It is very weak already, and there is the possibility that fiscal and monetary policy can improve with time, and that the economy can prove stronger than current expectations call for.